Home Builder Sales at Risk Due to Rising Mortgage Rates

Sales of newly built homes rose to their highest level in five years in May, according to numbers compiled by the U.S. Census, but those numbers are at risk of being wrong. They are based on signed contracts, not closings, for homes, many of which have not yet been built. Those contracts were signed well before a huge spike in mortgage rates, and those closings could be up to nine months away, when the homes are completed.

"We've been talking a lot with salespeople across the country to get a read on the current situation," says Stephen East, a home building analyst with ISI Group. "Sales people are very worried about it. Customers are worried that they cannot yet lock in, and they are watching the rates get away from them. I do think cancellations will climb."

The 100 basis point move higher affects the monthly payment by 13 percent, according to East.

Of the sales contracts signed in May, according to numbers compiled by California-based analyst Mark Hanson, 31 percent were for completed homes, so buyers likely would have locked in their mortgage rates near record lows. Those deals would close easily. And 24 percent were for homes under construction. Some buyers may have locked in a rate if the home was almost done, but some likely did not.

The biggest risk is with the rest of the contracts. Of the signed contracts in May, 36 percent were for homes that were not yet started. Completion and closing would be anywhere from three to nine months out. Those buyers, in most cases, could not lock in mortgage rates yet. Rates are up a full percentage point from the beginning of May and continue to rise.

"Bottom line, 70 percent of all May 'sales' are suspect with respect to locked mortgage financing, which is a key metric to how much the buyer can pay for the house," says Hanson.

"Not all of these will fall out. Some will move to a higher-risk adjustable rate mortgages in order to save the deal. However, builder sales fall-out will spike and the May new home "sales" number will be revised sharply lower unless rates comply or builders help to soften the blow of the house being 20 percent more expensive to own than originally thought."

Stephen Paul, of Mid-Atlantic Homes, a small private builder based in Maryland, says he is now getting calls from concerned customers asking about rate locks.

"The challenge of course for a loan lock for a home that's under construction is that they never know when they are going to actually have their closing dates," says Paul. "The cost of doing a loan lock up to nine months runs 2 1/2 points and a lock for three months is 1/2 point, so people are trying to judge on whether they want to invest in that loan lock."

Lengthy loan locks could cost buyers thousands of extra dollars, which on the lower end might not be affordable and could scuttle the deal. While some builders can complete a home in 100 days, labor constraints have been slowing construction across the industry.

"A lot of the sub-contractors are seeing an increase in business, yet they're reluctant to hire staff or have an inability to hire skilled labor, so we're seeing delays with framers coming onto our properties to frame the houses, we're seeing challenges with drywall finishers and painters," says Paul.

Many builders are also seeing supply constraints, as they did not expect to see such a surge in demand. Demand is strong in large part because there is such a small supply of existing homes for sale nationwide, and because banks have been exceedingly slow to work through foreclosures in some states.